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Digging Into DeFi #2
Welcome back to my series on decentralized finance (aka DeFi) for beginners. In the last post we looked at Bitcoin and I explained how you can get started with the original blockchain and it's increasingly popular currency of the same name ??
Soon we're going to be learning all about the Ethereum Blockchain and the many useful apps and currencies that call it home ?? We'll talk about smart contracts and how they redefined what blockchain is and can be. And we'll discuss the enormous DeFi ecosystem on that blockchain ?
For this post, there's a subject I wanted to talk about that kind of lives between discussions of Bitcoin and Ethereum: consensus mechanisms ?? Wait wait, hear me out. This is really interesting! Because we're also gonna talk about how to make really impressive financial returns through staking, lending, and liquidity mining ??
But, for what I'm about to say to make sense, we're going to need a quick refresher on what a blockchain is and how it works ?????
Blockchain 101
A blockchain is essentially a decentralized ledger or database ?? What this means, is that much like a bank maintains a list of all transactions to verify that the money has been placed in the right accounts at the end of each day, so too does a blockchain maintain such a list, only instead of the transactions being written by one central actor (which requires immense trust) ?? the transactions are simultaneously verified by many computers (or pools of computers) called nodes at once. This allows for a decentralization and democratization of power ?? The entire LEDGER can be verified by anyone, at any time meaning that forging transactions to the ledger (aka fraud) is very difficult by design ??
Currently, maintaining the ledger in a "trustless" way, which is to say without delegating trust to a central authority, requires a certain amount of randomization. That randomization comes in the form of mining. Mining is actually the verification of the transactions to the ledger, and it's done by determining complex cryptographic sequences called hashes. Basically, imagine picking a number between one a trillion, and whoever picks correctly (first) gets paid for their work verifying the transaction. ??
This method creates a form of labour in the system, which has tremendous value. For this reason, miners are compensated with newly minted currency. In fact, the title miners is given because they essentially dig up the currency and add it into the market ? Through their work, transactions on the blockchain are verified (or proven), thus this system is called Proof of Work (or PoW for short) ??
Critiques of Proof of Work
There are a couple of critiques of PoW systems that you may have heard already. One critique that we hear often is that PoW requires tremendous energy ?? Now this is undoubtedly true, but the way this critique is used to overstate the negatives of Bitcoin, and worse, to devalue the technology of blockchain as a whole, is frankly offensive. For one, PoW systems are entirely agnostic to the kind of energy being used. So if miners wanted (or were required by legislation) to mine using privately run renewable energy sources, so as to neither create a carbon output, nor drain public resources, the point would be effectively moot ??
Another critique, and perhaps the more valid one, is that whoever has the most money, can buy the most computing power, thereby centralizing the power of the blockchain, and leaving the door open for a 51% attack. This is a very real concern, given that currently the largest Bitcoin mining pools in the world operate out of China and there is very little transparency around state involvement ??
Yet another critique argues that the amount of computing power being used is unnecessary and that this amount complex computing power could be used for other purposes such as developing new medicines or finding solutions to climate change ??
Now, before the Bitcoin purists come for me, I want to point out that I do hold Bitcoin (as you'll see if you read on ?? ) and I do not think that the critiques of Proof of Work are sufficient reasons to avoid Bitcoin altogether, but rather reasons why other cryptocurrencies hold the potential to work alongside Bitcoin or potentially supplant its dominance in the future ??
My reading on this subject has led me to a great amount of optimism with respect to Proof of Work's most well established alternative: Proof of Stake (aka PoS) ?? ...not that kind of steak! ??
Proof of Stake
In a PoS system, validators don't focus on a set amount of compute power, but rather need to lock in (or "stake") a set amount of the currency. In the Ethereum PoS system which will become the standard in Ethereum 2.0, validators must stake 32 ETH (today worth around $150,000 CAD). Though smaller investors, as we'll discuss, can participate in staking pools ??
Now you may be thinking that just like the rich could potentially take over a PoW system, by buying all of the hashpower, so too could they take over the PoS system by staking enough money ?? While this does not appear to be wrong (based on my understanding) it is far less likely than in a PoW system. Firstly, the validator is chosen randomly, making it very unlikely for validators to be conspiring together. Secondly, rather than 51% of the hashpower being needed, an attack in a PoS system would require 51% of all the Ether in circulation, which at the time of writing would be over $200B USD making it an unlikely bet for even the richest humans alive today ??
So now that I've given you an absurd amount of preface I can finally talk about what this article is really about: making money ?? You see, just like miners are rewarded for the energy they spend, validators are rewarded for the value for their stake. This value, comes from newly minted currency (which comes online in designated amounts just like it does with mining) ?
In practice this looks a lot like receiving interest on term deposits in the current fiat financial system. You stake an amount of cryptocurrency (likely as part of pool) and receive a set payout based on the period (or term) of your investment ?? Staking rewards vary by currency, but they are almost always well beyond what you could earn through traditional investing ??
I discovered staking by happy accident. Remember, I'm still very fairly new to cryptocurrencies, but I find the space so interesting that I'm constantly reading and watching videos to learn more. With respect to fiat currency, I like the idea of putting my money to work through means like investing and high interest savings ?? So when I started holding cryptocurrencies, I wanted to do the same. That's when I learned about yield farming (aka liquidity mining) ?
Liquidity Mining
Basically liquidity mining is a bit like lending. You lend your currency to provide liquidity to the market and you earn a share of the transaction fees. Because decentralized exchanges (or DEXs) use Automated Market Makers (or AMMs) which is just a smart contract that regulates trading, there is no central source of capital for liquidity. For that reason, liquidity providers are incentivized to lend their capital through receiving the trading fees that the end user paid to trade ??
This might sound a bit complex, but that's because it is ?? Much of what happens on Wall Street by experienced traders with backgrounds in finance is being replicated here. In essence the curtain is being pulled back, and access being democratized. But that doesn't mean you should jump in head first. Do you own research, starting by reading the rest of this post ??
The fee amounts on decentralized exchanges are pre-set which means the estimated returns you'll see on a platform like Cake DeFi are reasonably accurate. What got me interested in liquidity mining after-all was the rate of return, which compared to traditional finance seems impossible, often in the 80-100% range ?? But again, while these rates may not be available to consumers, this is effectively what the financial market makers and bankers are doing every day with fiat currencies.
Providing liquidity is always done through pairs of tokens. I feel like I might risk losing you if I abstract from my point any further, so I'll save that for another day, but I do recommend that if you're interested in learning more that you do some follow up reading on liquidity pools (here's a good place to start).
If you have some money set aside for crypto investing and you want to get started right away, I can only recommend you what I personally use: Cake DeFi. Their transparent principles including concise transparency reporting, registration in Singapore, and compliance with Know Your Customer (KYC) regulation, make them a trustworthy institution in my opinion. But as I already mentioned, you MUST do your own research. Do not take my word for it ???>?
I put my Bitcoin that I earn through passive income streams like Coinmiles and Fold (Bitcoin reward apps), and my payouts from NiceHash Mining into Cake DeFi for liquidity mining at roughly 90% APR ?? The DeFi Chain ($DFI) tokens that I earn, I put into Staking at variable rates that can get as high as 100% or more of APR ?? The reason I do both is because I like to take my liquidity mining rewards (both $BTC and $DFI), and put them back to work. $DFI is able to be staked, while Bitcoin is not (remember it's a PoW blockchain) but Cake does allow me to lend bitcoin on a monthly basis for between 5-7.5% APY ??
I hope that this all made sense. If not, read through it a few times, and even check out some of the links for further reading ?? I feel like this subject really bridges the gap between Bitcoin and Ethereum. While they both currently operate on a Proof of Work model, Ethereum is on track to change this, and many other cryptocurrencies are already using Proof of Stake. With Cake DeFi I'm able to put my Bitcoin to work with the help of PoS blockchains and decentralized finance infrastructure ??
If you view investing cryptocurrencies like investing in stocks, this may not be for you. However, if you view these assets as true currencies, then maybe like me, you want your money make you money. The fiat way to do this is finance. The cryptocurrency way do this is DeFi.
More on that in the next article ??
Summary
Staking is an alternative to crypto mining for blockchains that use the Proof of Stake consensus mechanism
You can earn returns on your investment through staking
The same services that offer staking, often offer liquidity mining (aka yield farming)
I use Cake DeFi for my liquidity mining, staking and lending because I am impressed by their transparency and long term roadmap. There are other services like this that I may try in the future, but I will only ever recommend products and services that I personally use.
Referrals
If you'd like to give Cake DeFi a try, use my referral code, and you'll receive a $30 bonus in the form of staked DFI tokens when you deposit $50 or more of fiat or supported cryptocurrency. In addition to Bitcoin, cake allows for liquidity mining of Ether, Litecoin, Tether, Bitcoin Cash, and Dogecoin ??
If you need some cryptocurrency (that's a good first step after all), check out Newton Crypto ???? for $25 free when you trade your first $100. You can also check out Gemini who operate in the US ???? and 50+ other countries ?? for $10 free when you trade your first $100.
PS, if you're looking for a hardware wallet, you should check out this bundle from Ledger.
Until next time ??
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Brand assets from Cake DeFi and Ethereum.org, used as permitted.
Doge and Bitcoin images from NicePNG
